Thursday, 7 July 2016

Tax deductions aren't that great

At least not for the majority of people. While I don't have the specific numbers available, it looks like the ATO withhold about 25% of salaries for tax purposes. This means for the average Australian income (according to google) of $80,000, they hold about $20,000. This brings us to the first important point relating to taxation.

You don't get back more than you put in.

It doesn't matter how many deductions you have, a tax refund is exactly that - the return of the excessive tax that you paid over that financial year. Whatever the tax your payment summary says you paid is the very most you can ever get back. Keep this number in mind to set up realistic expectations for your return The least amount of tax you can pay is zero, with the most less than 45% (source: https://www.ato.gov.au/rates/individual-income-tax-rates). The effective tax rate for anyone will be always under 45% due to my next point.

Tax brackets only apply to a portion of your income

If you've ever had to fill in a tax return, you're probably familiar with the tax free threshold. Once you're above it, you start getting taxed at 19%. However, if you're in this tax bracket you'll never actually pay 19% of your salary in taxes - you won't even pay 10% because the only taxable part of your income is the part above the tax free threshold. If you're at the top of the bracket ($37,000) you'll get taxed at 9.65%. Here's how I worked that out

Tax Free Threshold = $18,200

Taxable income = $37,000-$18,200

Taxable income = $18,800

Tax paid = 19% of $18,800 = $3,572

Tax rate = 3,572/37,000 = 9.65%

While 45% is the theoretical maximum tax that you will ever pay, the only way to reach that about is to earn an incredibly high salary. A million dollar annual salary has an effective tax rate of around 42%. This leads into my third and most important point;

Deductions are just discounts

So many people I know have either justified something by saying they can claim it on their tax, or tried to sell me something by saying I can claim it on mine. But a deduction reduces your taxable income equal to the deduction. If you claim $100 in deduction, your taxable income goes down by $100, but you aren't saving $100. You're saving whatever the tax was on that $100.

Say a person with a $37,000 salary bought $1000 worth of stuff on that they could claim as a deduction. When their tax return gets processed, they'll get back the tax that was paid on that part of their income, which in this case was $190. While this certainly isn't bad, it's a discount that you may have to wait up to a whole year to get, depending on when you made the purchase.

For this reason, I believe that low to medium income earners should do their own taxes rather than hire a tax accountant. If you hired an accountant for $100, and you earned $37,000 in a year, they'd have to find over $500 more deductions than you would in order for it be value for money - though their services count as a deduction next financial year so in reality it would be closer to $400. If you're not confident to do one yourself, there are government helpers for using the e-tax system. Chances are if you're in this pay range your tax return isn't going to be too complicated.

Conclusion

The point of this article isn't to scare people out of claiming deductions or out of using accountancy services. If you have something that you can claim, you are entitled to, and should do so. Similarly, if you want to pay someone to make your life easier, go ahead. However, we shouldn't go out of our way to make purchases for the sake of saving on taxes. If tax deductions are a major part of a decision, think about if you think that a reasonable price for the product is 19-45% off the asking price. If it's not, then it's not worth it from a tax perspective. Be sure to also keep in mine that if what you purchased wasn't something that you needed, in the end, regardless of the deductions, you're just wasting money.